Economics of Commodity Markets

September 16-17, 2016
Jing Yang of Bank of Canada; Kenneth Singleton of Stanford University; and Wei Xiong of Princeton University, Organizers

Trade and Sourcing in Energy Markets

Farid Farrokhi, Purdue University

Global Sourcing in Oil Markets

Trade in oil accounts for 12-15% of world trade, but occupies a small part of the trade literature. This paper develops a multi-country general equilibrium model that incorporates crude oil purchases by refineries and refined oil demand by end-users. Farrokhi begins by examining data on the crude oil imports of American refineries, then estimates the model by deriving a new procedure that combines data on refineries’ selected suppliers and purchased quantities. Using the estimates to simulate the effects of counterfactual policies on oil trade and prices, Farrokhi finds: (i) A boom in crude oil production of a source changes the relative prices of crude oil across countries modestly which the researcher interprets as the extent to which the behavior of crude oil markets deviates from an integrated global market. (ii) By lifting the ban on U.S. crude oil exports, annual revenues of U.S. crude oil producers increase by $8.9 billion, annual profits of U.S. refineries decrease by $7.1 billion, while American final consumers face a negligibly higher price of refined oil. (iii) Gains from oil trade are immensely larger than gains from trade in the existing models designed for manufacturing.

Frank Wolak, Stanford University and NBER

Assessing the Impact of the Global Diffusion of Shale Gas Technology on the Global Coal Market

Wolak develops a spatial equilibrium model of the world coal market that accounts for coal to natural gas switching in the electricity sector in the United States and Europe, the potential for China to exercise monoposony power in its coal purchasing behavior, and the impact of increasing the western U.S. coal export port capacity. The global coal market equilibrium is computed as the solution to a nonlinear complementarity problem. Where possible parameters of the model are estimated econometrically. Where this is not possible the parameters are calibrated to global coal market outcomes in 2011. The model is used to assess how the shale gas boom in the United States impacts global coal market outcomes for different models of Chinese coal buyers' purchasing behavior and different scenarios for the capacity of coal export terminals on the U.S. west coast. Although reductions in U.S. and European natural gas prices reduce coal consumption in the U.S. and Europe, the percentage reduction in coal consumption in Europe is much less than that in the U.S. Increasing U.S. west coast port capacity increases coal exports from the western U.S. and reduces Chinese coal production. U.S. coal prices increase which causes more coal to natural gas switching in the U.S., further reducing global greenhouse gas emissions. Modeling China as a monopsony buyer of coal reduces the absolute magnitude of these impacts.

Financial Trading and Price Pressure in Commodity Markets

Martijn Boons and Melissa Prado, Nova School of Business and Economics

Basis-Momentum in the Futures Curve and Volatility Risk

Boons and Prado propose a new commodity-return predictor related to the slope and curvature of the futures curve: basis-momentum. Basis-momentum strongly outperforms benchmark characteristics, such as basis and momentum, in predicting commodity spot and term premiums in the time series and cross section. The basis-momentum effect is varying within the curve of a single commodity, driven by roll returns, present in currency markets, and increasing in volatility – all consistent with maturity-specific price pressure. Asset pricing tests show that a parsimonious two-factor model provides an excellent cross-sectional fit, with a large premium for exposure to basis-momentum that largely represents compensation for volatility risk.

Ignacia Mercadal, University of Chicago

Dynamic Competition and Arbitrage in Electricity Markets: The Role of Financial Players

Over the last decade, many electricity markets have introduced purely financial trading alongside transactions between operators who own physical generation capacity and entities, such as utilities, that serve physical demand. As it has been in other markets, the effect of these financial trades is the subject of an ongoing debate; while they are expected to increase liquidity and informational efficiency, they have also been blamed for higher prices and led to allegations of price manipulation. In this paper Mercadal studies the role of financial trading by examining a natural experiment in the Midwest electricity market. A 2011 regulatory change exogenously attracted more financial players to this market, and a rich dataset on individual behavior allows the researcher to study both physical and financial participants' reaction to it. First, Mercadal uses a reduced form analysis to show that the regulatory change lead to more financial trading, and less generators’ market power. She then uses a structural approach to examine the causal relationship between these two observations, which requires the computation of the residual demand faced by each firm. A major challenge here is that electricity markets are segmented by transmission lines with limited capacity, which creates local markets in which only a subset of the firms competes. Mercadal deals with this issue using techniques from machine learning, presenting a new method to study the competitive structure of electricity markets. Her findings indicate that financial trading decreases generators market power, but does not fully eliminate it. As a consequence, consumers are better off but productive efficiency might go down.

Risk Premia in Commodity Markets

Reinhard Ellwanger, Bank of Canada

Driven by Fear? The Tail Risk Premium in the Crude Oil Futures Market

Oil prices are notoriously difficult to forecast and exhibit wild swings or "excess volatility" that are difficult to rationalize by changes in fundamentals alone. This paper offers an explanation for these phenomena based on time varying disaster probabilities and disaster fears. Using information from crude oil options and futures Ellwanger documents economically large jump tail premia in the crude oil derivative market. These premia vary substantially over time and significantly forecast crude oil futures and spot returns. The results suggest that oil futures prices overshoot (undershoot) in the presence of upside (downside) tail fears in order to allow for smaller (larger) risk premia thereafter. Ellwanger shows that this overshooting (undershooting) is amplified for the spot price because of time varying benefits from holding inventory that work in the same direction. The novel oil price uncertainty measures yield additional insights into the relationship between the oil market and macroeconomic outcomes.

Daniele Bianchi, University of Warwick, and Jacopo Piana, Cass Business School

Expected Spot Prices and the Dynamics of Commodity Risk Premia

Bianchi and Piana analyze a novel time series of investor expectations of future commodity spot prices, and provide evidence that survey predictions are extrapolative and inconsistent with a strong form of rationality. The researchers show that a model of adaptive expectations can replicate investor forecasts, and use this to back out the dynamics of the monthly (ex-ante) risk premia, as postulated by the theory of normal backwardation, for different commodities and maturities between 1995 and 2016. The empirical analysis demonstrates that commodity risk premia are time-varying and their dynamics is predominantly due to risk sharing channels and the changing demand for risk insurance and appetite, as proxied by open interest and hedging pressure. Time-series momentum and value factors also significantly generate time variation in commodity risk premia. In this respect, the researchers provide evidence that the explanatory power of diverse factors is not constant over time, both across commodities and time horizons.

Commodities and the Macroeconomy

Steffen Hitzemann, Ohio State University

Macroeconomic Fluctuations, Oil Supply Shocks, and Equilibrium Oil Futures Prices

What is the role of macroeconomic fluctuations and of oil supply shocks for oil prices, volatilities, and risk premia? Hitzemann analyzes this question within a general equilibrium asset pricing framework with an oil sector. The benchmark calibration shows that short-run shocks to macroeconomic growth and oil productivity shocks account for more than 90% of the volatility in the oil market and are responsible for the mean-reversion behavior of oil prices. On the other hand, long-run macroeconomic growth risks are the main driver of risk premia on oil futures and their upward-sloping term structure, which is observed in the data. The model consistently explains quantity and price dynamics in the oil sector and in the general macroeconomy, and furthermore sheds light on the intricate relationship between oil and equity returns.

Michael Brandt, Duke University and NBER, and Lin Gao, University of Luxembourg

Macro Fundamentals or Geopolitical Events? A Textual Analysis of News Events for Crude Oil

News about macroeconomic fundamentals and geopolitical events affect crude oil markets differently. Using sentiment scores for a broad set of global news of different types, Brandt and Gao find that news related to macro fundamentals have an impact on the oil price in the short run and significantly predict oil returns in the long run. Geopolitical news have a much stronger immediate impact but exhibit not predictability. Moreover, geopolitical news generate more uncertainty and greater trading volume, consistent with a disagreement explanation, while macroeconomic news reduce informational asymmetry and are associated with subsequent lower trading volume. Finally, the researchers find that news sentiment contains more information about future expectations than about future realizations of economic data.

Commodity Producing Economies

Jorge Fornero and Markus Kirchner, Central Bank of Chile

Learning About Commodity Cycles and Saving-Investment Dynamics in a Commodity-Exporting Economy

Despite sustained high levels of commodity prices, the current account balances of several commodity-exporting countries have deteriorated in recent years. Fornero and Kirchner examine this phenomenon quantitatively using a small open economy model with a commodity-producing sector under the assumption that agents have imperfect information and learn about the persistence of commodity price shocks. A central prediction of the model is that during a persistent commodity price increase, agents believe at first that this increase is temporary but eventually revise their expectations upward as they are surprised by higher than forecasted commodity price levels. Domestic investment therefore expands in a gradual way driven by investment in the commodity sector, while domestic savings decrease such that the current account declines over time. The model is estimated with data for Chile, and the results show that through the above mechanism the model explains several stylized facts regarding the recent evolution of the Chilean economy, including part of its step-wise current account reversal since the mid-2000s. Additionally, the researchers use the model to analyze the effects of a persistent commodity price shock under alternative monetary and fiscal policies.

Niko Jaakkola, Ifo Institute; Daniel Spiro, University of Oslo; and Arthur van Benthem, University of Pennsylvania and NBER

Finders, Keepers? (NBER Working Paper No. 22421)

Natural resource taxation and investment often exhibit cyclical behavior, associated with shifts in political power. Why do finders get to keep more of their discoveries in some periods than others? Jaakkola, Spiro, and van Benthem show such cycles result from the inability of governments to commit to future taxes and firms to commit to credibly exiting a country for good. In a cycle, large resource revenues induce a high tax which lowers exploration investment and thereby future findings, which in turn leads governments to reduce tax rates again. Tax oscillations are more pronounced for resources which take longer to develop, or following temporary resource price shocks. The researchers' tractable model provides the first rational-expectations explanation of resource tax cycles under endogenous exploration investment and threat of expropriation. They document evidence of cyclical behavior in several countries with both strong and weak institutions, and provide detailed case studies of two Latin American countries.

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